A primary concern in structuring foreign investment in U.S. Real Property is the tax obligation that will be the responsibility of the investor. Foreigners must contemplate the implications of U.S. tax rates on capital gains, taxes on disposition of the property (FIRPTA), and U.S. Reporting requirements. United States Real Property Interest (USRPI) is defined under IRC section 897(c)(1)(A) as a direct interest in real property (land, buildings, mines, wells, crops, or timber) located in the U.S., certain personal property (machinery and equipment) associated with the use of real property, and an interest (other than an interest solely as creditor) in any domestic corporation that constitutes a U.S. real property holding corporation[1] (USRPHC).
Establishing Residence
United States Residents and domestic corporations are taxed on their net income similarly to US Citizens. U.S. Corporate income taxes range from 15% to 35% and individual income tax rates from 10% to 39.6%. An individual is considered a resident for taxation purposes according to the following tests:
Green Card Test: If at any time during the year you are issues permanent resident status by the USCIS
Substantial Presence Test: physical presence in the US for 31 days during calendar year and 183 days in past 3 years.
Effectively connected Income
Nonresident aliens, those that do not meet the criteria for residency and foreign corporations are only liable for taxes on U.Ss Income that is (a) effectively connected with a U.S. trade or business (ECI) and (b) U.S. Source Income. Effectively connected income is taxed on a net basis at graduated rates (like a US Citizen) whereas non-ECI is taxed at 30% rate, also known as the “withholding tax”, unless otherwise reduced in a US tax treaty, usually collected at the source (when foreigner receives income).
Real Property Rental income
In connection to real property concerns, rental income and gains from disposition of property located in the United States is considered to be U.S. Source Income. Rental Income can be taxed through withholding or without withholding on a net-basis as effectively connected income (ECI).
Not Effectively Connected with U.S. Trade or Business
Ownership of property for personal use or income generated by property rents on a passive net least basis[2] is not taxed as ECI, but with a flat 30% of gross income withholding rate (or as reduced by US tax treaty). This requires IRS filing of form 1042-S Foreign Persons U.S. Source Income Subject to Withholding” And 1042 “Annual Withholding Tax Return for U.S. Source Income of Foreign Person
Effectively Connected with U.S. Trade or Business
The active management, development, and operation of real estate property or rental income that is considered to be effectively connected income will be taxed at graduated rates. Expenses such as maintenance, mortgage interest and depreciation may be subject to deductions from taxable income. IRS Forms 1120-F for Foreign Corporations and 1040-NR for nonresident aliens must be filed.
A U.S. Property investor can elect to treat income from property as effectively connected in order to avoid the withholding tax on rents and deduct expenses, such as depreciation. The foreign investor must file form W-8ECI Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected with the Conduct of Trade or Business in the United States. However, such an election cannot be made for interest income on debt collection, rental from personal property or if property is not producing income.
Real Property Disposition
FIRPTA, the Foreign Investment in Real Property Tax Act of 1980, subjects an income tax on foreign owners of Unites States real property interest when the property is disposed. FIRPTA is applicable to nonresident aliens and foreign corporations with United States Real Property Interest. This included U.S. real estate and shares in a U.S. real property holding corporation. According to Treasury Regulations any “transfer”, including sales, gifts, exchanges, changed in interest etc., is considered a disposition of property. If the property is held for over 12-months is it taxed as a long-term capital gain at 15% for individuals and between 15%-35% for corporations. FIRPTA requires that the foreign owned U.S. Property purchaser withhold 10% of the purchase price at closing and subsequently remit it to the IRS. The IRS Provides forms 8288 U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests” and form 8288-A Statement of Withholding in Dispositions by Foreign Persons of U.S. Real Property Interests. The foreign seller then completes U.S. Income Tax and is credited for the withholding tax. The FIRPTA withholding tax does not apply if the foreigner has received a withholding certificate by the IRS, after filing form 8288-B Application for Withholding Certificate for Dispositions by Foreign Persona of U.S. Real Property Interests, or if the USRPI are shares of a U.S. Real Property holding corporation that is traded on a stock exchange. Furthermore, the withholding tax is not applicable if the purchased property is to be used as a residence and is under $300,000. Domestic U.S. Corporations are not subject to FIRPTA’s withholding tax. Another method to avoid FIRPTA taxation is by the IRC 1031 exchange which allows the owner to defer tax payments on capital gains and use the earnings to replace the property under specified conditions.
| US Real Estate Investment Vehicles | ||
| USRPI | Advantage | Disadvantage |
| Nonresident Alien | Simple structure
Lower Income Tax Rate Deductions where debt connected to US trade or business |
Full legal liability
FIRPTA withholding on sale US Estate and Gift Tax |
| Foreign Corporation | Income Tax rate + state income tax
No US Estate or Gift Tax Limited liability |
FIRPTA Withholding of 30% or treaty rate
Interest Stripping limitation Foreign Person Guarantee rule Branch profits Tax- Reinvestment Issues |
| Foreign Corporationà US Corporation | Income Tax rate + State income tax
No US Estate or Gift Tax No Branch profits Tax Limited liability No FIRPTA Withholding on Sale Limited liability |
Possible Double Taxation
Interest Stripping limitation Foreign Person Guarantee rule and interest-stripping limitations Tax Withholding |
| Us Corporation | Income tax rate + State Income
No US Gift Tax No Branch Profits Tax No FRPITA Withholding Limited liability |
US Estate Tax
Possible Double Taxation Interest Stripping limitation Foreign Person Guarantee rule and interest-stripping limitations Tax Withholding |
| Limited Liability Corporation (LLC) | Pass=through individual Federal Tax rate if classified as partnership instead of entity | US Estate Tax & US Gift Tax
1445 Withholding |
- Foreign corporations that operate a branch are subject to a Branch Profits Tax, in addition the U.S. Corporate Tax, on their effectively connected Income. Corporations that do not engage in a US trade or business are not subject to this tax. However, if the corporation is selling US Real Property Interest is will be subject to the additional BPT. 26 U.S.C. § 884
- U.S. Estate Tax IRC section 2103 & Treasury Regulations § 20,2104-1(a)(1)
- U.S. Gift Tax IRC section 2511(a) & Treasury Regulations § 25.2511-1(b)
- Tax Withholding 26 U.S.C. § 1441/1442
- Foreign Person Guarantee rule and interest-stripping limitations IRC § 163(j)
[1] USPRHC: a corporation who’s USRPI makes up at least 50% of the total value of its real property interest and business assets.
[2] Definition of net lease: Where the renter/ individual paying the lease pays rents, taxes, expenses, repairs, principal on mortgage and insurance premiums connected with property (IRS)